Wednesday, September 12, 2012

Is QE3 justified? Comparing current conditions with 2010

As the financial markets widely anticipate an aggressive easing action from the Fed (to be announced on 9/13), it is once again worth making a comparison between the conditions that lead to QE2 in 2010 and the current financial/economic conditions. The goal is to focus on the factors that central bank asset purchases can actually impact as opposed to those that the FOMC wishes to influence. Here they are:

1. Central bank balance sheet expansion can reduce financial stress in the system (similar to what happened in 2008). Here we compare the Westpac US Financial Stress Index as well as the VIX index for the the past couple of months with the same period in 2010. The current period basically has no financial stress at all (the more negative number for the stress index indicates lower stress).

2. Quantitative easing can also lower rates (both consumer and corporate) via fixed income asset purchases. The long-term treasury rates are already negative when adjusted for inflation expectations (see post) which wasn't the case in 2010. Both mortgage rates and corporate HY bond yields are near their historic lows. It's not clear if the Fed can push these rates much lower, and even if it could, we may be at the point of diminishing returns. A 3.5% or a 3.25% mortgage rate will not make a difference in most people's decision to buy a home. Much below that and the real rate approaches zero - not something many lenders/investors will be interested in particularly when they are asked to take risk.

3. By increasing bank reserves the Fed could encourage more bank lending. Here is an updated chart on US bank lending now and in 2010 during the same period. Many US banks are already near their limit with respect to how fast they can execute due diligence and close on loans. Adding reserves is not going to make them move any faster (unless credit officers are asked to take on more risk than banks are comfortable with - and we all know how that movie ends.)

Source: FRB

4. Quantitative easing will also increase prices of "risk" assets, particularly if valuations are near distressed levels. Both equity and commodity prices are already appreciably higher than in 2010. That has increased consumer net worth, yet has had little impact on consumer sentiment (see discussion).

Job creation, which is what Ben Bernanke focused on at Jackson Hole, can supposedly be improved via the mechanisms above. However financial stress conditions, corporate and retail interest rates, and bank lending are all in decent shape already, while risk asset valuations are not anywhere near "distressed levels". "Improving" these further may prove far more difficult than in 2010 as the Fed tries to squeeze the last few basis points out of rates (and push VIX down to 13?). As discussed earlier, it will certainly not generate a great deal more in payrolls. The "unintended consequences" however may pose further risks to the economy (discussed here).

Even if QE was justified in 2010 (some would argue it wasn't), additional monetary expansion certainly can not be justified in the current environment.